Corporate Bond Trading a Casualty of QE and ZIRP

The Financial Times has an article on how corporate bond dealers are going to create a new trading hub to try to preserve their market position while “boosting liquidity” in the market. Narrowly speaking, there’s nothing wrong with the piece as a description of investor unhappiness and planned bank responses. But it curiously missed how Fed policy has helped generate conditions that are reducing corporate bond trading liquidity. A key section:

Banks have agreed to create the venue, which includes new functions for exchanging large amounts of corporate bonds, at a time when their revenues from trading fixed-income products have fallen sharply thanks to a combination of low volatility, new regulation and competition from non-bank trading platforms such as Bloomberg and MarketAxess.

Big investors in corporate bonds have complained that the retreat of so-called dealer-banks from trading debt has led to a dearth of liquidity in the market – meaning they are unable to transact in the bonds without greatly impacting the price of the securities.

However, even putting aside the impact of new technology entrants and every bank’s favorite scapegoat, ZIRP and unnaturally stable markets alone are sufficient to explain low liquidity. The article (and the investors) seem to accept the premise that it is the dealers’ job to generate liquidity. That is a backwards premise.

The reason that many financial markets, such as corporate bonds, operate on an over-the-counter basis, where dealers make markets. That means that unlikes stock brokers, they acting as a principal and taking the other side of the trade, either taking the corporate bond into their inventory or selling the bond out of their inventory.

Why does corporate bond trading operate like that when stocks have long been bought and sold on exchanges? The big reasons are the nature of the market and investor behavior. Every time GM or Intel issues new shares of common stock, they are fungible. They are identical, from an investor standpoint, to existing shares. Not so with bonds. Each issue is distinct, with its own maturity, interest rate, interest payment dates, and other particular features (covenants, sinking fund, etc.). Moreover, a significant portion of bond investors have a long-term orientation, and don’t trade bonds unless circumstances change considerably.

Finally, unlike stocks, where one company’s stock would not be seen as a ready substitute for another (if you want to buy Apple, you’d not be happy if your broker tried selling you Citigroup), bonds are bought and sold on their attributes: interest rate, maturity, duration, credit risk. So an investor isn’t generally looking to buy a particular company’s bond. Rather, he is looking for corporate bonds (or mortgage bonds or other types of bonds) with certain characteristics that fit his objectives.

With that background, let’s go back to the Financial Times article. So investors are unhappy with liquidity? I’d hazard that that’s due primarily to the Fed and investors themselves. Back in the stone ages of finance, before high and volatile interest rates in the 1970s changed investor behavior permanently, corporate bond trading (and bond trading generally) was a remarkably sleepy business. Most investors were buy and hold. When the level of interest rates and their term structure (as in the shape of the yield curve) became uncertain, it was daunting for investors to figure out how to position themselves. Their defense was to readjust their holdings as conditions changed.

Now we haven’t gone back to the steady and low interest rate days of the 1960s, but ZIRP and QE and faith in the Greenspan/Bernanke/Yellen put have brought as as close as we’ve been since the turbulent 1970s. With interest rates not moving much on the short and even on the long end (compared to historical norms), one would expect less trading activity. Moreover, the lack of volatility (and corresponding changes in the yield curve) makes it harder for dealers to sell bonds when they take them into inventory. Investors have less reason to rejigger their holdings, which results in it being harder for bond traders to place or get investors to swap bonds.

Even with funding costs low, dealers have good reason not to want to take on a lot of inventory. What do you think the likely direction of interest rates is? Up or down? Higher interest rates mean losses on bond inventories. And dealers are structurally long. There isn’t enough capacity with credible counterparties for major dealers to hedge their bond position, much the less go net short. So their best protection is to keep inventories on the skimpy side if they think interest rates will rise.

I am not privy to the details of how this corporate bond trading hub might work, but some of the Financial Times’ sources argued that the banks had “skin in the game” by virtue of spending money on the hub and therefore had an incentive to make it work. The only problem with that view is that there was a big effort to create a multi-dealer bond platform in the 1990s that turned into a hugely costly development fiasco, and another in the tail-end of the dot-com era that never got off the ground. While the technical issues may have been ironed out, I’m dubious of Mary Jo White’s idea that you can make the corporate bond market more like the stock market. Outside certain benchmark issues, most bonds don’t trade that often, so the idea that there will be useful price quotes (meaning current enough to be indicative) is questionable. And one has to assume that the trading platforms have picked off those comparatively liquid bonds already. Thus, the purpose of the dealer hub may be to use the promise (whether it is delivered or not) of better trading of all those other “trade by appointment” corporate bond issues to regain ground in the more liquid corporate bonds traded on the non-bank platforms.

The close of the story was correctly skeptical:

Dealers will be required to stream a minimum number of price quotes and Tradeweb says investors will have a 95 per cent certainty of getting their orders filled.

Some bankers have pushed back on the idea that the platform will address issues raised by big investors. One banker asked: “Is this really the same market structure with a different name or is this putting in fundamental changes to address the problems that the buyside is complaining about?”

I’m not sure how you measure or enforce “95 percent certainty” particularly with no time frame or other parameters stipulated. As for the buyside grumbling, some of the market structure problems are the direct result of the inherent nature of corporate bond trading, made more pronounced by Fed policy. Bond investors seem to forget that they got a fantastic ride from the Fed’s asset-price-goosing program now that they are stuck with some of the adverse, unexpected consequences. And history shows the success rate of turning pigs’ ears into silk purses is thin indeed.